Time for Tax Reform

Today, the President's Economic Recovery Advisory Board (PERAB) was scheduled to release its recommendations on reforming the tax code. Although they have postponed their release until after the holidays, the need for comprehensive tax reform is no less urgent.

The current tax code is in many ways broken – it is inefficient, distorts behavior, stifles economic growth, and raises insufficient revenue to fund current or projected levels of government spending. It cannot be fixed in a piecemeal way.

And given our dismal fiscal picture, reform will need to occur sooner rather than later.

The PERAB is expected to offer an almanac of options “relating to tax simplification, enforcement of existing tax laws and reform the corporate tax system without considering policies that would raise taxes on families making less than $250,000.”

There is no question that the tax code needs to be simplified, the tax gap closed, and the corporate tax system fixed. But while necessary, these reforms are not sufficient. As Congress debates tax reform, we believe they should also do the following:

  • Make rational and deliberate decisions on the Bush Tax Cuts. At the end of next year, all of the 2001/2003 tax cuts are set to expire. They include lower marginal rates at every level, an expanded child tax credit, a new 10% bracket for lower-income earners, lower rates on capital gains and dividends, a phase-down of the estate tax, fewer “marriage penalties,” and several other provisions. Letting all of these cuts expire would probably be politically impossible, yet renewing them would cost roughly $2.3 trillion over the next decade, greatly worsening our already dreadful debt situation. Policymakers must think carefully and reach rational decisions as to which provisions should be allowed to expire, which should be renewed, and which should be modified – preferably in a more thoughtful manor than simply renewing them for everyone under a certain income threshold. And they should find a way to finance the costs of whatever they do renew.
  • Enact a permanent AMT fix. The Alternative Minimum Tax (AMT) is a secondary tax system originally intended to capture higher-earning taxpayers whose tax liabilities were below a preset threshold; but because that threshold was never indexed for inflation, the AMT is now scheduled to hit an increasingly large number of upper-middle- and middle-income earners. In past years, Congress has taken action annually to prevent the AMT from hitting the middle-class by passing temporary “patches,” which do adjust the threshold for inflation. Changes should be made in a permanent manner instead. A popular option is to index the threshold to some measure of inflation, which would cost around $450 billion over the next 10 years. If policy makers decide to do this, they will need to find offsets. The state and local tax deduction may be a logical pay-for for a number of reasons, but myriad other tax and spending options exist as well.
  • Broaden the tax base. Almost all economists agree that the tax base should be broadened. The current tax system has upwards of $1 trillion a year in deductions, exclusions, credits, and other tax loopholes; and these tax expenditures likely lead to both higher than necessary tax rates, and larger than necessary deficits. And in addition to being expensive, tax expenditures tend to be distortionary, causing people to make sub-optimal choices and driving up the price of things like health care and housing. They also tend to be quite regressive in ways that most voters never realize, and are far less transparent than equivalent spending programs. Policymakers should take a careful look at all current tax expenditures to decide which ones can be eliminated, which can be capped or reformed, which can be consolidated, and which simply belong on the spending side of the budget.
  • Consider the viability of new forms of taxation. Given the limitations of the current tax system, possible new sources of revenue are being increasingly mentioned. Most recently, for example, a financial transactions tax (FTT) has been discussed.  Some forms of an energy tax should certainly be considered, as it would raise revenues and promote improved energy and environmental policies. A somewhat more significant change might be to switch, perhaps in part, to some form of a consumption tax -- perhaps a progressive consumption tax or value-added tax (VAT).  Consumption taxes tends to be popular with economists since they can generate significant sums of revenue while encouraging savings and investment.

To summarize: at a minimum, tax reform needs to simplify the tax code, close the tax gap, reform corporate taxation, address the expiration of the 2001/2003 tax measures, fix the AMT, and broaden the tax base. We should also consider new types of taxes, and if it becomes evident that this not enough, we should seriously entertain moving toward a consumption-based system.

And even doing that cannot – and should not – replace tough and painful measures to bring spending under control.

While this all might seem like a tall order, its magnitude reflects that of the problems we face.